Reconsidering the Relation Between Profit Efficiency and Noninterest Income

Abstract

Profit efficiency is closely related to value creation, and researchers have found noninterest income to be a major determinant of profit efficiency. But DeYoung and Rice suggest that some banks have an excessive reliance on NII, pointing out that 1% of banks generate 18% of fee income, and that these are not the most profitable banks. Other studies support this view. This suggests that there is some optimal range of NII/Assets, and beyond that point bank profit efficiency declines. We test the hypothesis that NII reduces profit efficiency at some point and find no support for the hypothesis. Specifically, considering bank holding companies (BHCs) from 1996 through 2018, for all size groups, profit efficiency increases as NII increases. A significant source of NII for some BHCs is the provision of correspondent banking services, and these have been found to exhibit economies of scale. They have low variable cost once the correspondent relationship has been established (often many years in the past). This point helps explain the concentration of NII at a small number of banks and reconciles our results with others.

Keywords: Profit Efficiency, Noninterest Income, Stochastic Frontier Analysis, Correspondent Banking

JEL Classification: G21, D02